Pension bonds' backers see roses, but not thorns

To hear the Blagojevich administration's financial experts tell it, Illinois is in danger of missing an irresistible investment opportunity.

If only it would act right away, they say, the state could take advantage of some of the lowest interest rates in memory to address one of its toughest problems--paying for pensions.

Gov. Rod Blagojevich on Thursday appeared to have revived his plan for a $10 billion bond issue to bankroll the investment after the Senate only a day earlier narrowly rejected the idea amid Republican complaints that it could further undermine the state's dicey financial position.

But after some arm-twisting by the Democratic governor, a handful of Republicans said they would join with Democrats in the Senate to give the proposal the necessary support when it is called again for a vote, perhaps as early as Friday.

The debate over the pension bond proposal, which the House has already approved, is putting a rare spotlight on a sophisticated form of borrowing.

Pension obligation bonds, as they're called, burst into prominence in the world of public finance a decade ago, with decidedly mixed results. And while strapped municipalities and states across the country are talking about the pension bonds again, Blagojevich and his fiscal team have staked much more on these controversial financing tools than any other player by far.

Blagojevich hopes to rely on the bonds to cover more than $2 billion in pension-fund obligations through mid-2004. In a stroke, that maneuver would erase as much as 40 percent of the projected deficit.

How did an obscure form of debt become a centerpiece of Illinois' effort to put its fiscal house in order? The state's embrace of pension obligation bonds reflects everything from the predictable reluctance of legislators to cut spending or raise taxes to the salesmanship of a downtown Chicago financial firm.

Pushing hard for the deal is Lawrence P. Morris, a Mesirow Financial investment banker who is advising the governor's fiscal team. "People all over the world will have an interest in this bond," he said in an interview. "Rates are very, very low. We're very confident this is the right time to borrow. We're near the trough."

But skeptics such as Republican state Treasurer Judy Baar Topinka see only "a very dangerous, risky move." "The guy who comes to your door to sell you something always says act now," said Topinka. "This cannot be bought on faith."

The key to the transaction is Blagojevich's contention that the state can earn more money by investing the bulk of the bond sale proceeds than it will have to pay out to those buying the bonds.

The plan calls for Illinois to pay less than one percentage point above the rate for Treasury securities. In the current market, a taxable, 30-year Illinois pension bond would go for just under 6 percent. All $10 billion of the offering would be sold in just a few months, Mesirow anticipates.

The big source of controversy is the handling of the proceeds. The goal is covering the state's obligations to its undercapitalized pension funds for teachers and other employees. The five funds are short an estimated $35 billion, meaning they miss out on significant gains over time. By law, the state is required to make up the difference at a rate of 8.5 percent annually.

That requirement is "the gorilla of gorillas," said budget director John Filan.

About $2 billion of the proceeds from the bond offering would substitute for payments the state is supposed to make out of its main checking account through June 2004. In the short term, that helps plug a big hole in the budget.

The balance from the offering of just under $8 billion after fees and prepaid interest would be handed over to the pensions, reducing their shortfalls and giving them the opportunity to put the money to work.

This is where the assumptions draw fire. To offset the 6 percent that Illinois expects to pay on the bonds, the funds would need to earn an investment return on that $8 billion of at least 8 percent over the long haul.

While Filan and Morris point to the relative success of the pension funds over the bull market of the past 20 years, when average annual returns comfortably exceeded that level, others are much more skeptical in light of the current market volatility. As state Rep. Art Tenhouse (R-Liberty) puts it: "Warren Buffett can't guarantee that rate of return."

In a recent report, Wilshire Associates, an investment firm, predicted the long-term returns of Illinois pension funds would average 7.14 percent to 8.08 percent. Achieving higher returns would inevitably involve taking on more risk, Wilshire noted.

Others object to taking on debt to make pension payments through 2004 instead of cutting spending or raising revenues. That could put the state's credit rating at risk, potentially increasing the cost of future borrowings.

Moody's Investors Service already has the state on a watch list for a possible downgrade because of its budget woes, and a massive offering of pension bonds is unlikely to help, said analyst Tim Blake. "This could increase the fiscal pressures in 2005."